Life changes radically upon the arrival of a baby. While a baby does stand true to its moniker of ‘a bundle of joy’, there is no denying that there is a spike in expenses. A major expenditure in the upbringing of a child goes towards the child’s education. No parent wants to compromise on their child’s education. A recent survey found that 53% of the parents surveyed listed saving for their kid’s college as a top financial priority. Educational institutions too have harped upon this evergreen demand to flush the market with innovative educational ‘packages’ and options. The obvious result has been that the cost of education has shot through the roof.
The cost of education in the US has increased nearly three times in the last three decades. According to the nonprofit College Board, the average in-state cost for a single year at a four-year public college or university in the US for 2019-2020, including fees, room and board, was $21,950. For students attending an out-of-state public college, that figure jumps to $38,330. For a private college, it was $49,870. The monetary load on the parents in the wake of such appalling costs cannot be underplayed.
A Sallie Mae report states that 8 out of 10 parents reported that they are willing to stretch themselves thin in order to give their children the best of available opportunities. 92% said they believed college savings is an investment for their child’s future. However, less than half of the people who participated in the study had a solid plan to pay for college.
College experts too emphasize on planning well and beforehand to meet rising education expenses. Moreover, hiring a financial advisor to help plan your expenses can go a long way in easing financial worries for parents. Remember that the onus is on parents to plan holistically and start saving at the right time to secure sufficient funds to cover the high education costs.
Here are the ten most effective ways that parents can financially plan for college:
1. 529 college plans:
Whether you have an 18-year-old or a one-year-old child, setting up a 529 college plan can help you stay ahead of the curve when it comes to planning for college education costs. The 529 plans are one of the most popular avenues that parents in the US use to save for a child’s education. The 529 college plans are state-sponsored, tax-advantaged plans that can adequately cover higher education costs. These college-saving plans allow you to invest your after-tax dollar funds into different secure bonds and low-cost stocks, offering optimum diversification too. The money you invest in this plan also grows tax-free. Further, you can take tax-free distributions from your 529 college plan, provided the funds are used for qualified education expenses. Some examples of qualified education expenses include tuition, room, board, and books. Alternatively, if you use the distributions from this plan to cover any non-qualified expenditure, the IRS (Internal Revenue Service) will levy income tax charges, in addition to a 10% penalty. The income tax and penalty are charged for the earnings part of the non-qualified 529 distribution. However, note that each state has different rules governing its 529 plans. According to the US Securities and Exchange Commission, all 50 states, plus the District of Columbia, offer at least one type of 529 college savings plan. And since each of the US states has different rules and benefits concerning their state-sponsored college saving plans, it is best to understand each state’s 529 plan in detail and then select the best policy.
It is beneficial for you to invest in a 529 college plan early in life. The compounding power of money will help you accumulate more wealth over a longer time duration than if you start investing in later stages. Therefore starting early could help you adequately cover your child’s educational expenses. According to a report by the College Savings Plan Network, the 529 college plans reached the highest level of $352.4 billion in assets in the initial half of 2019. Even though these plans suffered a blow during the primary onset of COVID-19 (bringing it down to $293 billion in March 2020), the plan is regaining popularity, owing to its competitive advantages.
Apart from the tax benefits, the 529 plan allows you to change your beneficiary in the future. So, if the present beneficiary of your account does not require the funds, you can flexibly alter the designated beneficiary to name another child as the beneficiary of the same plan. Each state offers a different limit for contributions to the 529 plan which is typically between $235,000 and $529,000. Nonetheless, you should be careful with 529 plan withdrawals to avoid any penalties and ensure you apply for the distributions well in advance.
2. The 529 prepaid tuition plans:
529 prepaid tuition plans are also an effective medium to prepare for college financially. These plans focus on covering the tuition fees for your child – the burdensome part of educational costs. This cost has traditionally been rising every year, and going into the future, is expected to rise by almost 5% each year. With a 529 prepaid tuition plan, you can pay the entirety or a portion of your child’s education fee in advance. The advance fee is set as per an aspiring university or institution.
These plans work similar to a 529 college savings plan, but they allow you to pay the future education cost in the present. This enables you to avoid the steeply rising inflation in tuition costs in the future. Besides a prepaid tuition cover, these plans also offer tax-deferred growth for your funds. They have no upper income or age bars. The ultimate contribution limits are defined by each state and are usually high. Similar to a 529 savings plan, the 529 prepaid tuition plans also permit you to change your beneficiary in the future. However, if your child decides to quit studying or secures a full scholarship, the 529 prepaid tuition plan becomes disqualified. You can avoid plan disqualification by either naming another child as a beneficiary or withdrawing money after paying a 10% penalty.
3. Coverdell education savings account:
You can also plan for college financially using the Coverdell education savings plan. How a Coverdell plan functions are very similar to a tax-deferred trust where you can contribute after-tax funds. The funds in the account grow tax-free, and the withdrawals are also exempt from taxes. The accumulated corpus of the Coverdell education savings account can help you pay for your child’s elementary, as well as secondary educational charges. However, as per the rules, the account distributions from this kind of account are tax-free only when they support qualified educational expenses. Any sum used for non-qualified expenses will attract tax penalties. The account balance is distributed once the designated beneficiary reaches age 30 unless it is a special needs beneficiary. As per the Coverdell education savings plan, qualified education costs include primary and secondary school tuition, uniforms, tutoring, and other K-12 expenses. The scope of qualified expenditure in this account is wider than that of 529 college savings plans. Besides offering these advantages, the Coverdell account also has a broad investment choice in comparison to a 529 savings plan. However, you cannot save more than $2,000 per beneficiary per year in this account. Even though you can hold multiple accounts for the same beneficiary, your aggregate contribution cannot exceed $2,000 in all.
4. Roth IRA:
Roth IRA (Individual Retirement Account) is one of the most popular and coveted retirement savings accounts. However, apart from being a vehicle for retirement savings, you can also use it to save for your child’s education. Roth IRA allows you to save after-tax dollars, earn tax-free growth, and later take advantage of tax-free withdrawals. Owing to the triple-tax benefits, you can leverage your Roth IRA money both to support your golden years, as well as fund your child’s future. A Roth IRA is more advantageous than other retirement savings plans since it offers flexibility and significant tax benefits. The highlighting feature of this account type is that because you invest with after-tax dollars, you can avoid paying taxes later in life when you would be earning more and falling in a higher tax bracket, or when you retire and have no stable sources of income like a salary to fall back on. Moreover, there are no Required Minimum Distributions (RMDs), and you cannot take drawings before the age of 59.5. This gives your savings a longer period to prosper. Further, you also benefit from a wider investment basket, ensuring maximum growth potential. Above all, when you save in a Roth IRA, you have the freedom to choose how you wish to use your funds, unlike other educational plans like 529, 529 prepaid plans, and Coverdell education savings accounts.
On the flip side, these accounts come with contribution limits. For 2020 and 2021, the IRS only permits you to deposit $6,000 annually. If you are above the age of 50, you can contribute an additional sum of up to $7000 annually. For contributions made above the specific limit, the IRS levies a penalty of 6% every year until the error is revised. Also, ultimately, this is a retirement account that you will be diverting funds from. Therefore, you may have to struggle a bit to close the gap after the fund requirement for the education of your child is met in order to get the retirement you dream of having.
Trusts are not just for the rich. Trusts are one of the most effective ways to plan for college financially. You can set up an educational trust and use it to fund your child’s education costs in the future. The education trust will hold listed assets on behalf of your child for a defined period. Once the tenure is over, the assets are transferred to the child. Alternatively, you can also invest in structured/custodial accounts, such as UTMAs (Uniform Transfer to Minors Act) or UGMAs (Uniform Gift to Minors Act). In these plans, you allocate assets in your child’s account and invest on their behalf until they reach the legal age of trust termination. The legal age of trust termination age depends on the state of trust establishment. It is usually between 18 years and 21 years. The main benefit of using a trust to save for your child’s future is that there is no restriction or penalty on money usage. However, you should set some terms regarding trust money usage because this flexibility could leave the child splurging the money for non-related purposes. That said, even though trusts lower your estate tax burden, you cannot change the beneficiary later in life.
6. Life insurance policies:
You can also use permanent life insurance policies as a college savings vehicle. For each dollar you pay as a premium, a part of it goes to provide life cover, and the remaining portion is diverted to a distinct cash-value account. This cash-value account can be used to fund your college tuition. Generally, whole life insurance plans work best for such scenarios. In these plans, the insurance provider credits your account by a defined sum (or more if investments perform well) at a predetermined frequency. Typically, you can expect a return of 3-6% on such policies. The cash value grows tax-deferred like a 529 plan. You could also choose to invest in variable life insurance. This particular plan will allow you to choose and govern your investments. Your account’s annual return relates to the underlying investment securities. This can result in potentially high rewards, but there is also a greater risk of volatility. Besides, you can use these insurance policies as collateral for a loan to pay for your kid’s education expenses in the future. The insurer will reduce the death benefit of the cover if you do not pay back the loan. This is not a disadvantage if you intend to use the insurance solely to finance education.
Another approach to fund college expenditure is to look into scholarships. Outside scholarships can help pay for your child’s tuition fee. Scholarships can be merit-based or offered based on financial need, or could be a combination of both. You can start looking for student scholarships early in life to cover a significant portion of the expenses. Moreover, this will also help you prepare your child in the right direction to secure a scholarship. There are many scholarships available, so you must compile a list of them along with their deadlines, requirements, financial aid, rules, etc., and apply to the ones that best suit your child’s requirements and merits.
8. Other retirement savings plans:
In addition to using Roth IRA to support your child, you can use other retirement savings plans like a traditional IRA and 401(k). 401(k) accounts are employer-sponsored, tax-advantaged, and defined contribution plans that allow you to invest pre-tax dollars in stocks, bonds, mutual funds, etc. Your employers may also make some matching contributions to your 401(k) plans. This will enhance your corpus, enabling you to cover college costs more adequately. However, the IRS permits you to contribute only up to $19,500 in your 401(k). But if you are 50 years or above, you can make an additional catch-up contribution of up to $6,500 in 2021. The earnings in your 401(k) account are tax-free, but the withdrawals are taxed at applicable income tax rates. You can use 401(k) savings to secure your child’s future because there is no usage restriction on these funds. In the case of an IRA, you make pre-tax contributions and get tax-free growth of funds. But when you withdraw the money after you attain 59.5 years or later, you pay taxes on the fund drawn. This is beneficial, as you could accumulate significant wealth and then defer your taxes to a future when you would likely be in a lower tax bracket post-retirement. Take note of the IRA contribution limits and income eligibility restrictions. The yearly contribution cap for 2019, 2020, and 2021 is $6,000. However, if you are 50 years old or above, the contribution cap for all three years is $7,000.
9. Home equity loans:
An option to pay for college can be home equity loans. You can use your home as collateral and take a loan to cover your child’s education costs, provided the interest rates are favorable. However, this option comes with pros and cons that require a serious discussion with a financial advisor.
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The first advantage of these home equity loans is that you get lower interest rates than private student loans, especially if you have a high credit score. You can also borrow a higher amount than traditional student loans with a longer tenure for easy payback. On the other hand, a home equity loan can prove risky as you could end up owing more mortgage than your home is worth. And if you are unable to pay back the loan, you could lose out on your house too.
10. PLUS and private loans:
As per studies, 3.6 million parents use PLUS loans to help their children pay for college. You can also utilize these loans if the other options are not a perfect fit with your plans for college funding and your financial portfolio goals. In PLUS loans, you can borrow an amount as high as the college tuition fee by using the Free Application for Federal Student Aid (FAFSA). To ease the financial strain, the federal government offers different ways to pay back your PLUS loans more conveniently. However, if you do not qualify for a PLUS loan or get a lower interest rate from a private lender, consider taking the private loan. Private student loan rates may be lower than federal loan charges if you have a credit score of 670 and above. It is critical to do your research, shop around, and choose a loan type that best fits your requirements. Be sure to understand all implications and do a comparative analysis.
As parents, the earlier you start planning for college, the better off you and your child will be. A sound investment plan, coupled with the right understanding of different college financing options, may help your child secure a valuable college degree without straining your monetary situation. It is best to start investing early and take a considerable look at all options. You can also seek professional guidance from a vetted financial advisor through Paladin Registry to help you choose the right way to secure your child’s precious future.
To learn more about the author William Hayslett view his short bio.
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